Swiss peg debacle leads to cull in FX prime brokerage
A series of market disasters in recent years, culminating in the SNB’s decision to abandon its peg to the euro, have forced banks to reconsider their commitment to the prime brokerage (PB) business, leaving many smaller hedge funds and other clients in the cold – but a new generation of providers is taking their place, promising to revolutionize the business.
“There has been a major shake out in the FX PB space after the EUR/CHF debacle,” says George Grech, head of the trade desk at Exante, which is described as ‘a next generation prime broker’.
Other providers are finding technology solutions to allow the smaller prime brokers and prime-of-prime houses to differentiate themselves
Grech argues the risk appetite of FX PB has been reduced significantly.
“The traditional FX PB firms have culled their clientele, leaving many fund managers, institutions and traders scrambling to find alternatives,” he says.
The appeal of prime brokerage for banks has been gradually chipped away by a number of notable market events, first Lehman and then the Swiss National Bank’s (SNB) decision to suddenly remove the CHF’s peg to the euro, which caused many traders with CHF positions to blow up.
If Lehman had implications for prime brokerage more broadly, the SNB’s decision was a disaster for FX prime brokerage specifically. And other events have contributed, too, including the rouble crisis of last winter/spring.
“Many operators significantly reined in their rouble risk, to the determent of their clients,” says Patrick O’Brien, director of communications at Exante.
However, Roger Rutherford, chief operating officer at ParFX, says the SNB’s move in January was more a catalyst that sped up the process, rather than its root cause.
“You could argue that an event such as the SNB decision – which caused a significant ripple throughout the market – while not necessarily causing banks to off-board clients may well have sped up reform in other areas,” he says.
Peter Plester, head of prime brokerage at Saxo Bank, says: “Pre-Lehman, prime brokerage was a very transactional, price-driven business and many banks only looked to cover their costs. There was no recognition of the inherent risks.
“After Lehman, and then again after the events of January with the Swiss National Bank, there is a much greater recognition of the risk, and banks need to make a reasonable profit to justify being in the business.”
It has all forced banks to reconsider the way they offer prime brokerage.
“Prime brokerage has traditionally been seen as separate to other services like custody and administration without much thought being given to cross-selling opportunities,” says Plester. “Now cross-selling is seen as a big opportunity, and those services are complementary.”
However, banks that look to offer these services as a package might run into problems when implementing Mifid II, which, unlike its predecessor, brings FX within its scope.
“Mifid II takes a much stricter line on unbundling,” says Fred Ponzo, managing partner at GreySpark. “When it is fully implemented in January 2017, banks will have to offer those services separately.”
The worry is, for a business that is already squeezing out smaller and less-profitable clients, this will make things worse.
The leading prime broker banks are not keen to discuss trends in the business, or their commitment to it, but as they reassess their prime brokerage operations, and shed all but their top clients, demand for these services is growing.
The market needs to take steps to reduce these risks itself,
Peter Plester, Saxo Bank
It is not just the smaller hedge funds looking for new providers, but a new generation of clients that have not used prime brokers before.
Andy Woolmer, managing director at New Change FX, a provider of independent reference FX mid-rates, says: “Demand for prime brokerage is still very high and we are seeing interest from new types of client, such as long-only funds.
“They used to stay away, but recently have discovered they can use their credit more effectively, by using prime brokers that enable them to pay 0.5 basis points instead of 5bp for FX execution.”
This is attracting a whole new generation of prime of prime (PoP) providers. These cater for smaller traders by acting as a credit intermediary, standing as the client of a traditional prime broker and passing on those services to its own clients.
Woolmer says: “It is still an attractive business. You now see hedge funds effectively financing prime brokerage directly, allowing them to access the risk and returns that banks do not want.”
IS Prime, for example, is a PoP business that opened in January by Jonathan Brewer and Raj Sitlani in conjunction with ISAM, a UK-based hedge fund.
Woolmer says this is likely to be just the beginning, adding: “In time, other investors will most likely come into the prime of prime space as well.”
Clearly, there is still a place for the banks. Saxo entered the prime brokerage business at the start of 2013, and has not been scared away by the events of January. It operates a PoP model, and the bulk of its clients are retail brokerages and asset managers, to which it offers direct market access to other prime brokerage platforms.
Saxo’s Plester argues banks that want to remain in the prime brokerage business must lead the business to new high standards, especially in risk management.
He says: “Recent scandals have put FX under the regulator’s magnifying glass and no doubt they see the allocation of credit, high-frequency trading and last-look pricing as weak links in the chain.
“The market needs to take steps to reduce these risks itself, like it did with CLS, which tackled the issue of settlement risk between institutions.”
Plester adds: “The use of margin is more prevalent in the prime-of-prime business, but for traditional prime brokerage, big clients tend to get credit, especially in FX PB. That is why many of the big players have been offloading their smaller clients.”
He argues those looking to stay in the business need to overhaul the way they manage risk.
“In the past, the FX prime brokerage sector has operated on post-trade risk controls,” says Plester. “The prime broker received the details of the trade and the impact on P&L by the platform or the trade counterparty as or soon after the trade was complete.
"At Saxo, we have built our infrastructure around pre-trade risk controls, which means our clients cannot break limits we impose and cuts out credit over-allocation.”
If prime brokers implemented better pre-trade risk controls it would be easier to manage their counterparty exposures, ensuring they did not exceed the margin they held against them. That would make it easier to manage business with smaller clients.
It also means clients have a kind of insurance policy that prevents them from losing more money on a trade than the collateral held by their prime broker.
Implementing pre-trade risk controls does have implications for latency, because trades need to be routed through an additional system, but this would only slow down trades by a few milliseconds.
“[However], the latency issue does not affect 95% of our clients,” says Plester.
Others, such as ParFX, are innovating in other areas: for example, the introduction of post-trade name give-up on its wholesale trading platform – whereby the system shows the names of the executing broker, prime bank and prime client, post-trade, to improve transparency.
“Equally, other providers are finding technology solutions to allow the smaller prime brokers and prime-of-prime houses to differentiate themselves,” says ParFX’s Rutherford.
“They are coming up with better pre-trade risk-management tools, kill switches and other innovations to better manage risk. You could argue they are raising the bar.”
So while many smaller prime brokerage clients have struggled in recent months to come to terms with being shunned by their bank providers, the ongoing shake-up promises to be good news for the business in the longer term.
A new generation of bank and non-bank providers with new ideas will inject new competition into the business. And while prices are higher now, ultimately this should see them driven down again.